Sunday, September 17, 2017

Three Concerns: EPS/Golden Calf, the Next Dip, Indexing is Faulting - Weekly Blog Post # 489


Most individual and institutional investors are in essence outer directed. Either consciously or not they follow what others do and have a fundamental belief in “smart money.” For extended periods of time this philosophy has worked. Perhaps, it was my brother’s experience in the US Marine Corps Reconnaissance as the leading point for wartime patrols to avoid walking into an ambush. Or my experiences at the racetrack where betting favorites won only about one-third of the time. I look for instances where the “crowd” is wrong. Not to be just a contrarian, but looking at the profit opportunities when the generally unexpected occurs. Some of these opportunities are just plain random, others can be perceived ahead of time. Each of this week’s concerns has some evidence backing up the views as to future changes. Whether you agree or disagree let me know.

Is EPS our Golden Calf?

Throughout my investment career I have heard earnings, actually reported earnings per share, drives the market. In the 1960s I was told all one needed to know was the growth rate of earnings to determine the appropriate price/earnings ratio. Recently I heard a very well known and respected Portfolio Manager explain in a long cable news interview that “earnings drive the market.” The first thing he said about each of his five buy recommendations was their earnings per share. The analyst in me rebels at this kind of over simplification.

In a period where much of senior managements’ compensation is based on in order, EPS, sales, and market price - do you think that they attempt to show the best possible record? I don’t want to proclaim that they are totally manipulated or are the equivalent of “fake news” but it makes you wonder whether it is a true reflection of the value and future potential of the company. One of the first lessons from my Professor David Dodd, who wrote the five editions of Securities Analysis with Ben Graham, was to reconstruct the financial statements of the company under study. We laboriously went through each line in the income statement and balance sheet adjusting for removal of non-recurring elements and questioned the accounting techniques that produced each item. We were quickly taught that in various cases the results in the press release or Management’s letter did not give a totally accurate picture.

When professionals discuss the valuation of various Merger & Acquisition deals today, comparing them to others, the metric that they use is EBITDA. This stands for Earnings before Interest (net), Taxes (paid or accrued), Depreciation (based on what schedule), and Amortization (what were the write offs?). The drive here is to understand what was the operating earnings of the company. Net Interest is the result of the financial condition  and policies of the company and might not be followed by a new owner. One of the simplest techniques that I learned at a trust bank was to put all the steel companies held in trust accounts on the same tax rate. This deprived some of the companies of their tax management skills, which were often transitory, but would be different under different ownership.

Depreciation charged is a function of the weighted ages of the plant and equipment with no adjustment for critical future expenditures. Amortization could be an orderly way to recognize the deteriorating value of intellectual property purchased and/or other write downs. To some degree I think all of these items plus debt service obligations are more important than reported earnings and so do the “M&A” troops.

Notice that a good portion of some companies “earnings improvement” comes from profit margin expansion. What this really means is that reported earnings are growing faster than sales. This is favorable when the company is increasingly earning more over its fixed cost base. However, it may mean that it is not spending enough on plant and equipment and/or research and development. These considerations are important in an increasingly competing world of relatively slow growth.

In history, when the ancient people felt that the Golden Calf  did not answer their needs, not only did they destroy the statue, there was a period of turmoil and violence until new, and in some cases, better beliefs were established.

The Dangers of Buying the Next Dip

This past week there was an extremely sharp jump in the portion of the American Association of Individual Investors views on the market. In one week 41% are bullish, a gain of 12 percentage point from the week before with a concomitant decline in bearish beliefs and neutral holding about even. Both the Dow Jones Industrial Average and the S&P 500 went to new highs, not immediately echoed by the NASDAQ Composite. It is quite possible that the two senior averages need to catch up with the NASDAQ. The year to date performance shows the performance gaps, DJIA +12.68%, S&P500 +16.88% and NASDAQ + 22.96%.

Could this be the key missing element to a race to the top? While a number of highly respected market analysts expect a minor pull back, as there are a few price gaps that should be filled in before a major new top is reached. This could be accomplished by a 5 to10% correction. The Goldman Sachs* view is that there won’t be a dip as too many people are expecting it. (Remember the humility production function of the market.) This focus on sentiment over financials is a concern of Professor Robert Shiller as expressed in The Sunday New York Times when he refers to John Maynard Keynes’ belief that market participants were not making their own investment decisions, but were guessing what others were doing, in other words, trying to follow “smart money.”
*Held in the private financial services fund I manage

My concern is that this trading attitude may actually succeed. The risk is that the successful traders and later their acolytes will have faith that it is a repeatable result, and they are truly skilled. My concern is that when the next “Big One” occurs it will be quite different than managing through normal drops and even minor corrections. The difference is the size of the trading capital in the marketplace having to provide liquidity to non-price sensitive ETFs and margin-called players. There is little to no capital on the floor of the exchanges. Dealers have capital constraints and banks are limited by various regulations in a global marketplace connected in less than nano-seconds.

I don’t worry about trading losses, they come within the territory of investing. What I do worry about is the potential of future revulsions to investing and a generation that will decide “never again.” This will be tragic for themselves and their families. But also the rest of us taxpayers who are likely going to have to pick up some of their missing retirement capital.

More Evidence Indexing is Faulting

You have to excuse me for looking at the world with lenses that start with mutual funds which I have been following for more than fifty years.
Each week I look at the funds’ performance for varying time periods. For the week ending last Thursday I saw an interesting pattern evolving. My old firm, now part of Thomson Reuters, tracks close to 100 different fund peer groups. The largest equity group is the $ 1.2 Trillion S&P 500 Index funds. I compared its results for three periods and counted the number of peer groups that beat the large Index funds as shown below:

Type of Fund
# of Fund Types Surpassing Index Funds

52 Weeks
5 Years
US Diversified funds
Sector funds

There were four fund types that beat the index in all three periods, 2 diversified and two sector fund types. The key point is more active managers are beating the Index. It is not because they switched from dumb pills to smart pills. It is due to greater variability of performance within the 500. Mathematically this splitting is called less correlation and greater dispersion. Within the Index there are some big winners and a few big losers which is meat to active managers, and in theory to long/short managers (hedge funds and the like).
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Sunday, September 10, 2017

7 Steps to the “Big One” - Weekly Blog # 488


One of the signs of a truly expert professional is the recognition that he/she could be wrong. This question should come up to those of us that have to develop a view on a series of futures. We should recognize that the only consistent product of following the swings in the market is humility. Actually I learned this first at the New York racetracks where it became obvious one could not pick the winner of every race and it was rare to be right even half the time. I learned that the real object of betting is to come away a net winner. Thus by proper picking, which we call analysis, and prudent handling of money, one could accomplish the goal by cashing winning tickets one-third of the time. Actually there are much bigger winnings to be had. The bigger winnings in the future come from examining one’s losing bets. Over time it becomes clear that there are a limited number of patterns to the losses which drive the analytical imperative to see whether repeated losses stem from a faulty system of analysis.

With that series of doubts in mind I am now rethinking my assurance in last week’s blog that any forthcoming market decline will be one of normal proportions and not the “Big One.” Because we think in numerical terms, a normal decline is between 10% and 25% and the “Big One” is more likely to be 50% or more and come around once within a generation.

Modeling “The Big One”

In last week’s blog I listed seven characteristics that described the lead up to one of the most famous market collapses, “The South Sea Bubble.” Summarizing the seven steps as follows:

  • Displacement
  • Credit and Monetary Expansion
  • Overtrading
  • Financial Distress
  • Fraud/ Malfeasance
  • Widespread Mistrust and Revulsion
  • Panic Selling
Looking at the current stock markets around the world with particular emphasis on the US, I only saw elements of the first two steps to a South Sea kind of collapse. This is particularly true with the lack of enthusiasm for most US stocks and equity funds. Even with Byron Wien and Bill McNabb, the retiring CEO of Vanguard lengthening the earnings forecast period to pull down the market price/earnings ratio to more attractive levels, most investors are using shorter time periods. (When I came into the professionals’ markets in the 1960s and early 1970s it was not unusual to be quoted five forward year P/Es.) Without this stimulus there is no need to fear a major decline and periodic declines will be of normal size. During normal declines, most high-quality long-term portfolios should be maintained in place. 

However harking back to my education at the track, maybe I am missing some other patterns which could lead to different conclusions. Perhaps I should be looking at what is happening in the bond market. This won’t be easy for me. In a study of single portfolio manager Balance funds it became clear to me that, with rare exceptions, the managers that performed well did so with only a portion of their portfolios. They were either good at stocks or bonds. This finding suggests that stock and bond mavens speak in different languages and don’t communicate well to the other side. (I am experienced as a stock fund and individual stock picker and rarely voluntarily use individual bonds.)

Are Bond Prices Peaking?

For more than a year the most favored type of mutual funds have been bond funds, with Intermediate Maturity Corporate Bond funds alone receiving $ 93 Billion on a year to date basis. This flow could well be the missing level of enthusiasm on the road to the South Sea list. This could also be moderating this past week. According to my old firm, this last week was the first week in thirty seven when there were net outflows in High Grade Corporate Bond funds. Corporate treasurers and investment bankers are counting on this demand, as 2017 expectations is for issuance to top $ 1 Trillion. If accomplished it would fulfill the second item on the list of expansion of credit. With a reasonable outlook that the US and other national governments will be running deficits this year, there will be an additional monetary expansion.

Perhaps the most intriguing element on the march to the South Sea is displacement. On the equity side I counted on the internet filling that role. With my eyes now focused on the debt markets I see a much more structural set of changes which are not obvious to most investors, individual or professionals. The first and biggest change is the role of collateral for speculative loans.

Years ago the brokerage industry could make a reasonable profit through simply charging commissions. It has been many years since equity agency brokerage business was profitable. A number of different financial products replaced traditional stock brokerage business by the larger firms. By far the biggest was the margin loan business where a brokerage house extended credit to an investor at a relatively attractive interest rate. In turn the brokerage firm borrowed money from a bank against the collateral that the borrower put up. With the decline in retail interest in trading stocks this source of revenues shrank. However, it has been replaced by supplying credit to various trading entities; e.g., Hedge funds. The most favored collateral for these loans is US Treasuries. The demand for treasuries is so high that the current yields average 1.77% and according to Eaton Vance their average performance on a year to date basis is 3.15%, which is materially better than similar performance for US agencies (a gain of 2.56%). In theory, the full faith and credit of the US Treasury is a bit better than those of US Agencies therefore the yields should be lower for the treasuries and generate slightly better performance. Thus one can believe that the treasury market is experiencing some displacement.

I suspect globally one form of displacement is in the nature of the collateral that is borrowed against. Moody’s* has noted that its Base Metals Price Index has gained 29% this year. It suggests that these gains may be due to an increased level of speculation rather than surge in user demand. Copper has risen 50% in this period. I believe that one has seen the top of the use of futures on iron ore and copper as collateral by various merchants around the world and particularly in the Far East. By the way there is a slight negative correlation over the last five years between a large basket of commodities and US stocks.
*Held in the private financial services fund I manage

There is still one other displacement element and that is Emerging Market Local Currency bonds and funds. This is the best single type of fixed income fund for the last three years and doing very well this year in part because a number of commodity producers are located in emerging markets. The number one ranking for three years may need to have a warning label attached to it. The single worst performance period to extrapolate into the future for investment purposes is three years. In a period as short as three years often the market is going in one direction. Going back to my race track experience the odds of continuing winning after three years is remote.

Two Possible Signs of a Bond Top

This week the iShares 20+ Years Treasury Bond ETF had a year-to-date gain of 10%, that is unlikely to continue. The 10 year US Treasury yield hit a low of 2.02% closing at 2.06%.  To me these represent unsustainable levels.

My Concerns

I believe a good bit the high quality fixed income trading is on borrowed money from the banks. This is akin to the period immediately before the Lehman crisis. The abrupt liquidation of fixed income collateral spread to credit concerns in the equity market, leading to a stock price decline. While the overall level of leverage in the system is probably less, so is the flexibility of both the majors and the regulators to act.

Please Help

Communicate with me and assure me that I don’t have to worry now.
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Sunday, September 3, 2017

Is the “Two Step” the Last Dance of the Bull Market? - Weekly Blog # 487


Many years ago when people actually held each other there a very energetic fast dance called the “two step” which exhausted the dancers and often at the end left them clinging to each other. I am wondering whether there is a reasonable chance that we are setting up a “two step” dance before we have the “big one,” a once in a generation major decline.

A Contrarian View of Current Sentiment

A basic belief derived from history is that the only attribute that market survivors share is a well earned sense of humility. A study of history through the ages, cultures, and fields of endeavor shows that at critical points most people are wrong, but not always. Viewing the current stock market through that lens raises the possibility that we can be on the edge of a meaningful market advance.

A number of good market analysts pay more attention to sentiments and shifts in sentiments than economic and financial ratios. There are a number of sentiment readings, some published in Barron’s each week. One that has caught my eye is the weekly readings from the American Association of Individual Investors which also parallels my sense of institutional investors thinking as indicated by changes in transaction volume. In the last three weeks the percentage of bullish individuals has dropped from 34.2% to 25.0% with only a minor increase in neutral views going from 33.0% to 35.1% with a major rise in the bearish column from 32.8% to 39.9%. One can understand that the current political and military events are matters of concern, but in theory investors should have longer term time horizons than day traders. Both my study of history in general and the learned analysis from the racetrack, suggests to me that the odds, not the certainty, is that the dramatic switch in sentiment is wrong.

Interesting to me is that market volume has not picked up. This indicates to me that while people are generally worried about conditions they are not now acting to preserve their wealth or that of their clients.

Stock Market Analysis

What is more interesting to me, particularly as an investor in some smaller cap funds, is that the NASDAQ index has gone to a new high. The older and broader indices both in the US and a number of other markets are in striking range of new highs. While the NASDAQ index did hit a new high on a light volume Friday, it did not go up to qualify as a clean breakout of a past trading range and could reverse and create a top. Recognizing I am intrigued with the possibility that the index will achieve a breakout velocity.

The tactical importance of a breakout, particularly if followed by others, is that the prior reversal patterns, called “head and shoulders” becomes a base for a material advance. The base will show a rather large volume of past sellers who may feel the need to get back into the market to participate in future gains. Often the past sellers left large relatively high quality stocks and now may feel the need to quickly catch up through more than normal (for them) speculative investing.

Thus a vigorous “two step” dance could be in our future.

Fears of “The Big One”

One way I attempt to keep up with investing globally is when possible to read English language foreign media both for their local and global views. Recently I read an article in The Star Online from Malaysia where Tan Sri Andrew Sheng who writes on global issues from an Asian perspective. While enjoying the 24.7% gain in the MSCI Emerging Market Index, he is concerned that we may be heading for a major drop. In this light he as we all should re-read Charles Kindleberger’s “Mania, Panics and Crashes” (Macmillan, 1996). He identifies the following steps to the collapse labeled the South Sea Company Bubble of 1720:

  •           Displacement
  •          Credit/ Monetary Expansion
  •           Over Trading
  •           Financial Distress
  •           Fraud, Swindles, and Malfeasance
  •           Revulsion, mistrust of shady products and intermediaries
  •           Panic selling

We have seen similar risks attached to a number of other panics before and after the South Sea Company Bubble panic. His bullish view is that he does not see enough similarities to today’s markets to fear  a repeat  panic.

The odds are that he is correct that the next decline will be one of the more normal falls. In the US context when we had floor specialists and other well capitalized broker/dealer trading desks this meant declines in and around 25%, not the once in a generation collapse of 50%.

However, as the job of a prudent analyst is to think the impossible thoughts. I look at the above itinerary to panic and feel we may be on a similar somewhat predictive path. One might suggest that either the internet or bitcoin qualifies as displacement. The key concern with displacement is that it is an excuse at least temporarily in believing old rules of prudence no longer apply. The growing lists of unicorn valuations for private companies that have little or no profits but with perceived great futures. It makes me nervous that some very good mutual funds are currently profitably benefiting from their private equity investments. Some less sound funds may follow and could have liquidity problems.

Our friendly central banks and deficit spending by governments and the growing number of new credit funds are certainly expanding money supply to the market systems. The mere hint of a “tapper” can cause both bond and stock markets to shudder.

At the moment most of the remaining sign points are not flashing great concern which is why I have not built reserves up in our long-term oriented mutual fund managed accounts. However, I am very concerned about the item of revulsion and mistrust of intermediaries. Some in the media are perfectly looking to shout “fire” in a crowded space. In addition, numerous politicians may act against all the intermediaries and their favored products. Their math is not based on dollars or other currencies, but on numbers of potential swing votes. As a critical element of self protection those of us who are professionals in the market need to have our clients and their beneficiaries understand that while we undoubtedly make mistakes, we are essentially honest and place them ahead of our own short-term financial interests.

It is a mistake to rest our relationships primarily on performance, particularly short-term performance.

With appropriate level of concern and caution I am still a believer that the process of prudent investing can generate longer lasting wealth than most activities, as long as it is based on our best efforts.

Momentary Input

On an intermittent rainy Sunday on the Labor Day weekend, the crowd at one of the glitzy shopping malls, The Mall at Short Hills, crowds approached the Christmas season levels. The big difference that I noted is that more men were in attendance, not just as bag carriers. They were actually shopping and often not in the company of female companions. At numerous stores there was a major effort to divert credit card sales to their home or co-sponsored brands. Retailers are also looking to capture long-term relations not just current sales. This is a necessary effort, hopefully it is not too late to keep any of the stores open for business in the malls.

Question: How quickly will your humility permit you to reverse some of your investment choices?                                

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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.